Why Do Economists Distinguish between Absolute and Relative PPP?

Why Do Economists Distinguish between Absolute and Relative PPP?

Article excerpt

In testing the purchasing power parity (PPP) hypothesis, economists have generally followed Frenkel [JIE, May 1978] by specifying equations in levels and first differences to represent absolute and relative PPP, respectively. These equations are given by:

[Mathematical Expression Omitted]

[Mathematical Expression Omitted]

where: s is the exchange rate; p is the domestic price level; and [p.sup.*] is the foreign price level (all measured in natural logarithms). The distinction is made on the basis of whether the relationship holds at a particular point in time (absolute) or between two points in time (relative). On the theoretical side, the distinction between absolute and relative PPP was first mentioned and attributed to Cassel by Pigou [QJE, November 1922]. It can be demonstrated that this distinction is empirically redundant, theoretically useless, and only emerged out of the misinterpretation of Cassel.

First, since data on aggregate price levels are not available, economists have to use price indices to test PPP. Since price indices measure price levels relative to a base period, using (1) must amount to testing relative PPP. Thus, (1) and (2) represent relative PPP in levels and first differences, respectively. If the variables underlying (1) are cointegrated, then (2) will be misspecified and so (1) will be the only valid representation of relative PPP. …